Mutual fund investments are subject to market risks. But investments in shares of mutual fund companies are subject to market risks as well as regulatory risks. This should have been obvious and priced into shares of asset management companies (AMCs). For some reason, it wasn’t. Shares of HDFC Asset Management Co. Ltd and Reliance Nippon Life Asset Management Ltd fell 8.7% and 12.5%, respectively, on Wednesday after the Securities and Exchange Board of India (Sebi) cut the maximum permissible limits for expense ratios charged to mutual fund investors.

In fact, HDFC AMC shares had strangely risen by over 12% soon after news reports emerged that Sebi had formed a sub-committee to review existing caps on expense ratios.

The correction in its shares was much-needed in any case, given that valuations had reached absurd levels. Note here that shares of AMCs haven’t been great investments globally, and some amount of caution with regards to Indian AMCs is warranted as well.

Sebi chairman Ajay Tyagi’s comments at an industry conference last month suggest that the review of expense ratios has partly to do with a high concentration of industry revenues and profits among a few large AMCs. The new slab structure favours funds that are relatively small in size over large funds. While it remains to be seen how mutual fund distributors adapt to the new structure, one possibility is that they would push mutual fund schemes that aren’t very large-sized. Of course, large mutual fund companies may also launch new funds to benefit from the new slab structure, although it’s not clear if Sebi’s circular will close this loophole.

The worrying bit for investors in large mutual fund companies such as HDFC AMC is that the regulator isn’t very pleased with the high market share of India’s largest fund houses. As such, regulatory risk can be alive and kicking for some time to come.

“Returns of asset management companies have, in general, been trending down for many years now. The cap on expenses ratios is one part of the equation; costs have been rising too, with myriad compliance requirements," points out a fund manager at a domestic mutual fund.

From the looks of it, HDFC AMC has been in a different league. Its return on invested capital has hovered around a robust 36% in the past two years, compared to 34% in the preceding two years. Among other factors, its healthy financial metrics had attracted investors to the stock. But even after the fall of about 29% from its peak, valuations remain rich at over 30 times forward earnings. And oddly, Reliance Nippon Life’s shares seem to be falling faster, despite its much lower valuation multiple. With earnings at risk for both firms, investors may hopefully become more realistic about valuations.